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Active and passive investing

What is the difference between active and passive investing?โ€‹

Active vs passive investingโ€‹

The central difference between the two investment approaches is around how often managers make investment decisions and review the portfolio.

Active investing is a hands-on approach where portfolio managers construct a fund that tries to outperform the average. They do this by continually analysing markets and trying to spot inefficiencies, like finding companies that are undervalued or industries that are about to be disrupted by a technological shift.

Individual investors can try to do this on their own, but it's more common to have an active fund through an investment company. Because you're indirectly hiring a team of expert research analysts and portfolio managers to make decisions on your behalf, these funds charge a higher fee on your investments (which they try to make up for in excess returns).

Passive investing, on the other hand, does not try to beat a market benchmark, but to match it. Usually, this means buying a simple product like an exchange-traded fund (ETF) that tracks an index like the S&P 500 or JSE Top 40. You can find passive funds that track specific geographic segments (like global funds, specific country funds, or regional funds), specific sectors (like real estate only) and even funds that only include companies that meet certain environmental or social criteria (like ethical and Sharia-compliant funds).

Because there is no active research involved once a passive fund is set up, these funds usually charge lower fees.

The case for passive fundsโ€‹

Critics of active investing say that active fund managers seldom manage to consistently outperform the market. The investment company S&P produces a biannual scorecard comparing active funds against their indexes, and finds that over the past 10 years:

  • In the United States: Only 10% of of active fund managers outperformed their index, and
  • In South Africa: Only 28% of active fund managers outperformed their index.

That's mostly because the fees of active funds are so much higher than passive funds, and very few active funds outperform the index by enough to justify those fees, as detailed by Morningstar.

It's also because in most countries with sophisticated financial systems there are so many people actively doing market research (not to mention complex pricing algorithms) that there are few bargains left to be found. Any foreseeable risks or opportunities for the business or sector are already priced in. This is called the efficient markets hypothesis, which suggests that everything that could foreseeably happen to the company is already reflected in the price. Any sharp movement in a stockโ€™s price is therefore the result of outside events that couldnโ€™t be foreseen.

Finally, passive investing advocates say that even though some active funds do consistently outperform the index, there's no reliable way for the average consumer investor to predict which one will.

Passive investing is often done by DIY investors who buy low-cost passive ETFs tracking local or global indices through investment apps and websites. Independent financial advisors can be consulted to help choose the right passive fund for the investor's goals, but this strategy does usually require a little more upfront research to choose the right passive fund.

The case for active fundsโ€‹

Even though the majority of active fund managers do not outperform the index, there are some who do. And a small proportion of funds beat the index by a lot. A passive investor canโ€™t outperform the market, as their return is the market benchmark minus the fees.

There are some contexts where active strategies might have an extra edge, notably:

There used to be a presumption that active funds would do better in very volatile or declining markets, but this hasn't really been borne out by the data from Covid-19, according to financial research firm Morningstar.

Active investing can be well suited to larger and more complex investment portfolios where the investor has very specific goals, like they're focusing on income-generating stocks or are targeting a particular risk profile.

The biggest benefit of active investing might be how simple it is. Active funds are usually purchased through investment companies, who also offer regulated financial advice and can tailor a portfolio to an individual's risk profile. They will typically take a percentage of the assets they're managing on your behalf as their fee.

So, which is right for me?โ€‹

Decide upfront which type of investor you are. Do you have the time and expertise to go it alone? Do you want to avoid the risk of choosing an active fund that underperforms the market? Do you have sophisticated needs for your portfolio, or are you happy to keep it simple?

You donโ€™t have to stick to one approach: thereโ€™s a place in a portfolio for both active and passive managed funds.

If you're new to investing, consider talking to an independent financial advisor (ideally, one that charges by the hour rather than a fee on your portfolio, so theyโ€™re not biased).

The most important thing is just to start investing. You can go months with analysis paralysis trying to decide what is the best approach. Changing your mind and moving your investments around later can cost you fees, but the biggest fee is the opportunity cost of not entering the market sooner.